Cash Isas limits should be slashed because they are fine to use as a rainy day fund but make a 'terrible' long-term investment, according to ex-Pensions Minister Steve Webb.

The total Isa limit is set to rise to £20,000 a year in April, but he urges a Government rethink on the cash element.

Webb, who is now policy director at Royal London, suggests a quarter of that - £5,000 a year - could be a more appropriate cash limit for people to build an emergency fund, while still having the opportunity to invest the rest for greater potential growth over the long term.

Save or invest? Cash Isas are popular, but returns are being massively outstripped by those from investments, while inflation has also wiped billions of pounds off their value

A new report from Royal London reveals that cash Isas are growing ever more popular with savers, but returns are being massively outstripped by those from investments, while inflation has also wiped billions of pounds off their value over the past decade.

Webb's firm calculates that £1,000 stashed in a cash account 10 years ago would be worth less than £900 in today’s money.

However, the same sum invested in a typical multi-asset fund - spreading money across shares, bonds and property - would now be worth more than £1,500.

This is the 'curse of cash', where it is the safest asset class in the short run but the riskiest over the long term, according to the report.

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* If all the money savers put into cash Isas over the last decade had been invested, instead of having £250billion sitting in these accounts they would now have around £360billion.

* Cash Isas needed to return more than £276billion to keep pace with a decade of inflation but only reached £250billion, which means £26billion worth of savings have been demolished over the past 10 years.

Should cash Isa limits be slashed?

Royal London policy director Steve Webb is calling for the reintroduction of a far lower cash Isa limit to protect savers from ending up out of pocket in the long term.

Cash and investment Isa limits were equalised after years of being set at different levels, and simultaneously increased to £15,000 in July 2014 (see the table below). The joint cash and investment limit is due to rise to £20,000 this April.

Cash Isa limits: The big rise came in July 2014 (Source: Royal London)

Meanwhile, financial experts fear the April launch of the new Lifetime Isa - allowing people aged under 40 to save for a home and retirement at the same time - could encourage people to save into cash versions of the new product.

That could divert savings away from auto-enrolment pension schemes where money is put into long-term investments.

Webb says there has been a surge of people saving into cash Isas since the limit was hiked a couple of years ago, but warns 'long-term money in cash Isas has been a terrible investment year after year'.

He says: 'When Isa were first introduced, the limits were quite low and the amount you could put into cash was less than the amount you could put into stocks and shares. This made sense and flagged that Isa were fine as short-term holdings of "rainy day cash".

'But the rules have changed so much that large numbers of people - over 10million contributed to a cash Isa last year - are shovelling money into cash Isas and seeing the real value of their savings erode, as well as missing out on potential investment returns.

Cash vs multi-asset funds: Investments are more volatile but have done better than cash savings over time (Source: Royal London)

'With Isa rates so low - sometimes below 0.1 per cent - and inflation rising there’s every reason to think that this problem will continue.

'We’re calling on the Government to look at reintroducing a separate and much lower limit on cash Isa investment – or be responsible for lots of "ordinary" savers thinking they are doing the "safe" thing by investing in cash only to miss out massively on investment returns.

'And in a world where very few of us is saving enough in the first place, we just can’t afford to do this.'

A Treasury spokesperson said: 'The government is committed to helping people to save and invest.

The report says: 'The problem seems set to get worse. The weakness of the pound since the [EU] referendum is helping to trigger a sharp rise in inflation. At the same time, the public policy response to the UK vote on Brexit means that interest rates are likely to remain "lower for longer".

'This means that money held in the apparently "safe haven" of cash will continue to erode in terms of its real value, potentially at an accelerating rate.'

Royal London says that in the meantime, the Government has been cutting tax breaks on pension saving – money that is often invested across a range of assets by default – while boosting tax breaks on all types of Isa, including cash Isas.

Its report says: 'Government policy is also encouraging an increase in the use of Isas for long term investment by way of continual reductions in pension allowances and increases in the amount that can be saved in an Isa.

'This nudges people in the direction of a savings vehicle that forces the choice of investment onto the savers themselves. Too much of this money is finding its way into cash.'

So where should you put your cash?

Royal London argues that multi-asset funds are a better alternative for long-term savers.

It says that in every single year since the financial crash in 2008, a multi asset approach would have outperformed holding cash (see the table below).

Which asset class has done best? How cash performs against different types of investments (Source: Royal London)

'While a multi asset fund spreading exposure across equities, bonds and property can suffer from greater day to day or year to year fluctuations, these asset classes have historically offered higher returns than cash and are more appropriate for long term investment,' says its report.

Trevor Greetham, head of multi asset at Royal London, adds: 'Isas are increasingly being used as part of a long-term savings strategy alongside pensions, but holding cash is not a sensible option when interest rates are close to zero and inflation is on the rise.

'In the short run, cash is safe but in the long run it is risky. Switching your money into a well-diversified multi asset fund limits volatility and should grow the real value of your capital over time.

'Anyone with large long term cash holdings should seek advice and review their investment approach as a matter of urgency.'

Saving surge: Amount going into cash Isas has jumped since limit was raised to £15,000 in July 2014 (Source: HMRC and Royal London)

Why do so many people favour cash Isas?

The amount invested in cash Isas soared by just over 50 per cent from just under £40billion to nearly £60billion between 2013/14 and 2015/16, says Royal London.

New investment in stocks and shares Isas rose by 16 per cent to around £21billion in that period.

Of the total £518billion invested in Isas, nearly half (48 per cent) is now held in cash. Some of the extra money now going into cash Isas could have been shifted across from ordinary savings accounts.

Royal London says that among people whose Isa holdings are exclusively in cash, more than three million people had balances of more than £30,000 in 2015/16.

'As this is in excess of the average annual wage in the UK, this suggests that these are more than short term "rainy day" savings and represent a long term investment for growing numbers of people.'

The firm puts forward three reasons why cash Isas are so popular, not just as an emergency fund but as part of a long-term savings strategy.

1) The instant access trap: 'If you tell someone they can access their money any time, they are more likely to invest in something offering a high degree of capital security,' says its report.

'They can imagine themselves taking the money out soon and would not like to see it drop in value in the meantime.

'It is impossible for younger savers to access money in a pension fund so they are more willing be more adventurous in their investment choices, typically checking up on the value infrequently and being pretty much insensitive to short term volatility.'

2) The accidental long run: 'An investor in Cash Isas may set out expecting to access the money in the relatively near term to smooth out dips in income or put down a deposit on a property, say.

'In reality these eventualities may not arise and they may be reluctant to take money out for fear of losing its tax protected status.

'Before they know it, time has passed and funds have built up. The short run has become the long run. Lifetime Isas, with their ambiguous short/long term savings objectives are likely to be particularly prone to this kind of time horizon confusion.'

3) Lack of good advice: 'Many investors lack good financial advice and information. Perhaps they don’t realise that since the separate contribution limits on Cash Isas were abolished it has been possible to switch funds accumulated in a Cash Isa into a Stocks and Shares Isa without losing their tax-protected status.

'Perhaps they aren’t aware that funds in a Stocks and Shares Isa can still be accessed quickly in case of emergency.

'Perhaps they are, understandably, put off by annual fees in Stocks and Shares Isas – though the analysis in this report assumed a realistic 1 per cent a year fee and we have assumed no benefit from active management in a multi-asset fund.'

Pension tax relief slashed since its peak in 2010/2011

Retirement pots: Limits on how much you can put in a pension pot every year and over a lifetime and benefit from tax relief have been reduced since 2010 (Source: Royal London)